Detroit Bankruptcy Focuses Attention on Pension Costs

Financially stressed cities across the country are watching carefully as Detroit comes to grips with its unsustainable pension and benefit costs.

Over half of Detroit’s $18 billion of accumulated debt is attributable to city pension obligations ($3.5 billion) and employee benefits ($6.4 billion). As the city’s population dwindled from 1.2 million in 1980 to 700,000 today, retiree ranks started to outpace current city workers. The Motor City now employs 10,000 workers, while struggling to provide costly benefits for 20,000 retirees.

When Detroit filed for Chapter 9 Bankruptcy on July 18, pension experts knew this would be a landmark case. Not only is Detroit the largest municipal bankruptcy in history, it is likely to explore previously unresolved legal conflicts between state and federal law.

Michigan’s constitution contains a pension protection clause, which states in part: “accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby.”

The use of the word “accrued” is argued to mean that Michigan’s pension plans do not protect “unaccrued” benefits, thus giving Detroit potential opportunities to cut back on pensions. The city reported that as of June 30, 2012 there is about $2.16 billion being held in trust in Detroit’s general retirement system.

Pension advocates, including unions and Michigan’s Attorney General Bill Schuette, will argue that the state constitution pre-empts a federal bankruptcy court from reducing pension payments and promised benefits.

Central Falls, RI, and Prichard, Ala., both made significant cuts to municipal pension benefits while in Chapter 9 bankruptcy. Kevin Orr, Detroit’s emergency manager, has stated that “there are probably going to be some adjustments,” in pension benefits because the city does not have funds to meet its obligations to retirees.

If Detroit is allowed to cut pension benefits, industry observers are bracing for a court battle. Reuters quotes Hank Kim, executive director of the National Conference on Public Employee Retirement Systems, as predicting, “It would be appealed almost immediately to the U.S. Supreme Court. It would set up a Constitutional crisis, with the Court asked to decide which is superior - federal bankruptcy law or a state constitution?"

Unlike corporate pension plans, municipal plans have no protection from the Pension Benefit Guaranty Corporation (“PBGC”). States are not allowed to declare bankruptcy, and city and county obligations must be met by the municipality, the state, or taxpayers. The White House has indicated its reluctance to offer any federal support to help Detroit.

Detroit must also still establish “eligibility” for its Chapter 9 bankruptcy filing, which requires the city to prove it meets five different factors. Criteria include the presence of insolvency, state authorization to file the bankruptcy, and “good faith” in advance of the petition for bankruptcy.

The reorganization suggested by the bankruptcy filing would allow Detroit to pay back all their secured creditors in full, pay their unsecured creditors (pension plans included) less than 10 cents on the dollar, and reinvest $1.25 billion for public safety. Needless to say, this reorganization plan is subject to protest by many creditors, bondholders, and retirees.

Detroit has made several attempts to address its unsustainable pension plan problem in the past. The city used complex financial swaps in recent years to solve the problem. Instead of alleviating the problem, however, the financial swaps led to an additional $1.4 billion in bonds issued by the city.

Moreover, the city borrowed from its own pension plan fund, creating an even bigger shortfall. In June the city finally defaulted on a $39.7 million payment for pensions.

Governor Rick Snyder reassures employees that the city will likely follow the state’s lead and move to a 401(k) type of contribution instead of the defined benefits pension plan currently offered.

In Summary

Detroit’s bankruptcy is the latest and most alarming step yet in what most likely will be a continuing series of municipalities struggling to close the shortfall on underfunded pensions and benefits. According to the Pew Charitable Trusts, “the gap between the promises states have made for public employees’ retirement benefits and the money they have set aside to pay these bills was at least $1.38 trillion in fiscal year 2010.” Likely pension litigation surrounding the dual sovereignty conflict may help to establish legal precedent for similar battles in other cities.

August, 2013

ABOUT THE AUTHOR: Mark Johnson, Ph.D., J.D.Mark Johnson, Ph.D., J.D., is a highly experienced ERISA expert. As a former ERISA Plan Managing Director and plan fiduciary for a Fortune 500 company, Dr. Johnson has practical knowledge of plan documents as well as an in-depth understanding of ERISA obligations. He works as an expert consultant and witness on 401(k), ESOP and pension fiduciary liability; retiree medical benefit coverage; third party administrator disputes; individual benefit claims; pension benefits in bankruptcy; long term disability benefits; and cash conversion balances.

While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.